Commentary: Higher US Taxes Are Coming

Martin Wolf, Financial Times

Wednesday, 13 Apr 2011 | 2:13 AM ETFinancial Times

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What does the rise of libertarianism portend for the future of the US? This is not a question of interest to Americans alone. It matters almost as much to the rest of the world. A part of the answer came with the publication of a fiscal plan, entitled “Path to Prosperity”, by Paul Ryan, Republican chairman of the house budget committee. The conclusion I draw is the opposite of its author’s: a higher tax burden is coming. But that leads to another conclusion: much conflict lies ahead, with huge implications for politics, federal finance and the US ability to play its historic role.

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Barack Obama

An analysis of the Ryan plan by the Congressional Budget Office makes the point. Its “extended-baseline scenario” assumes that current law remains unchanged. Under that assumption, revenue would rise from 15 percent of gross domestic product to 21 percent in 2022 and on to 26 percent in 2050. Spending would rise substantially, too, from 23¾ percent of GDP in 2010 to 30¼ percent in 2050. As a result, the deficit would fall from today’s levels while debt held by the public would rise to 90 percent of GDP in 2050.

As the CBO makes plain, this is an optimistic scenario. Current law includes, most notably, the assumption that the 2001 and 2003 tax cuts will expire, as legislated. Together with the impact of fiscal drag from economic growth and inflation, this generates the rising share of revenue in GDP. On the side of spending, the share of social security in GDP rises modestly, from 4¾ percent of GDP in 2010 to 6 percent in 2050. The share of all other spending (including defence), apart from that on health, is assumed to fall to close to its long-run average of 8 percent of GDP. But health spending explodes, from 5½ percent of GDP in 2010 to 12¼ in 2050.

The CBO also explores a far worse long-run scenario. In this, revenue rises only to 19 percent of GDP, around the long-run average, as tax cuts are extended and other fiscal reliefs are introduced. Spending is also a little higher. But the principal impact on spending comes from interest payments on exploding debt: debt in the hands of the public reaches 344 percent of GDP by 2050 and interest gobbles up 17 percent.

The conclusion is clear. If revenue were allowed to rise to 26 percent of GDP, modest adjustments to spending would secure sustainability. However spending, (including that by the states) would be at about 45 percent of GDP. With close to European spending patterns, the US would also need close to European levels of taxation. If the US persisted with historic revenue, relative to GDP, the fiscal position would become unsustainable.

Into this debate enters Mr Ryan, with a proposal that would keep revenue at 19 percent of GDP. But it would cut spending to 20¼ percent of GDP in 2020 and to a mere 14¾ percent in 2050. Debt would fall to negligible levels. No one can doubt that this plan represents a radical departure. But what may not have been obvious is just how radical – and just how implausible – it is.

The elaborated parts of the plan are for health. Support for Medicaid would be turned into block grants to the states, which would presumably cut back on support. Support for healthcare for the elderly would be turned into federal contributions towards private medical insurance.

Even these radical changes would leave the share of federal support for health spending at 5 percent of GDP. Yet this would also be 40 percent of the share forecast in the CBO’s baseline. The clever part is that the plan would only prevent people who reach 65 from 2022 from joining Medicare. Support for health insurance for the elderly would also be means tested and vary with the health of the beneficiary. Overall, suggests the CBO, the elderly would bear 68 percent of the costs of insurance by 2030.

As it notes: “That greater burden would require them to reduce their use of healthcare services, spend less on other goods and services, or save more in advance of retirement than they would under current law.”

The US has the highest maternal and infant mortality rates among the high-income countries, and among the lowest life expectancies. The result of these cutbacks in spending on health for the poor and the old would be further deterioration. Is this really politically acceptable?

Yet the plan has other surprising aspects: first, social security would be untouched; second, non-health, non-social security and non-interest, spending (“the residual”) would be cut to 6 percent of GDP in 2022 and be constant in real terms after 2021.

This residual category includes defence, most veterans’ programmes, mandatory spending on federal civilian and military retirement, unemployment compensation, earned income and child tax credits, scientific research and much else. The plan entails the almost complete disappearance of these residual functions other than defence, since it is hard to see why spending on the latter should fall much from the average of 4½ percent of GDP of the past decade. The rest would then be down to 1½ percent of GDP by 2022. Indeed, in the very long run, even spending on defence would collapse. Assume, for example, that spending on all the non-defence areas in the “residual” would be 1½ percent of GDP in 2050. Then defence spending would be a mere 2 percent of GDP. Is this a Republican plan?

Assume, instead, that “residual” spending returns to its long-run average of 8 percent of GDP. Assume, too, that spending on health is kept below 8 percent of GDP – an extraordinary turnaround. Then non-interest spending would still be 22 percent of GDP in 2050 and the fiscal deficit would be well over 3 percent. In short, revenue would have to be higher, even under these highly optimistic assumptions.

The Ryan plan is a “reductio ad absurdum” – a disproof by taking a proposition to a logical conclusion. It would turn the government into a miserly provider of pensions and health insurance. These functions would absorb three-quarters of non-interest spending by 2050. Other functions, including even defence, would collapse. This is most unlikely to happen. Indeed, even if the government were astonishingly successful in curbing the growth of spending on health, the share of federal spending in GDP is almost certain to be above 20 percent.

A long-term fiscal fight looms. The solution may even have to come out of a crisis. But Mr Ryan has given the president an opportunity, by defining what surely will not happen. Mr Obama must seize it.

What does the rise of libertarianism portend for the future of the US? This is not a question of interest to Americans alone. It matters almost as much to the rest of the world. A part of the answer came with the publication of a fiscal plan, entitled “Path to Prosperity”, by Paul Ryan, Republican chairman of the house budget committee. The conclusion I draw is the opposite of its author’s: a higher tax burden is coming. But that leads to another conclusion: much conflict lies ahead, with huge implications for politics, federal finance and the US ability to play its historic role.

An analysis of the Ryan plan by the Congressional Budget Officemakes the point. Its “extended-baseline scenario” assumes that current law remains unchanged. Under that assumption, revenue would rise from 15 percent of gross domestic product to 21 percent in 2022 and on to 26 percent in 2050. Spending would rise substantially, too, from 23¾ percent of GDP in 2010 to 30¼ percent in 2050. As a result, the deficit would fall from today’s levels while debt held by the public would rise to 90 percent of GDP in 2050.

As the CBO makes plain, this is an optimistic scenario. Current law includes, most notably, the assumption that the 2001 and 2003 tax cuts will expire, as legislated. Together with the impact of fiscal drag from economic growth and inflation, this generates the rising share of revenue in GDP. On the side of spending, the share of social security in GDP rises modestly, from 4¾ percent of GDP in 2010 to 6 percent in 2050. The share of all other spending (including defence), apart from that on health, is assumed to fall to close to its long-run average of 8 percent of GDP. But health spending explodes, from 5½ percent of GDP in 2010 to 12¼ in 2050.

The CBO also explores a far worse long-run scenario. In this, revenue rises only to 19 percent of GDP, around the long-run average, as tax cuts are extended and other fiscal reliefs are introduced. Spending is also a little higher. But the principal impact on spending comes from interest payments on exploding debt: debt in the hands of the public reaches 344 percent of GDP by 2050 and interest gobbles up 17 percent.

The conclusion is clear. If revenue were allowed to rise to 26 percent of GDP, modest adjustments to spending would secure sustainability. However spending, (including that by the states) would be at about 45 percent of GDP. With close to European spending patterns, the US would also need close to European levels of taxation. If the US persisted with historic revenue, relative to GDP, the fiscal position would become unsustainable.

Into this debate enters Mr Ryan, with a proposal that would keep revenue at 19 percent of GDP. But it would cut spending to 20¼ percent of GDP in 2020 and to a mere 14¾ percent in 2050. Debt would fall to negligible levels. No one can doubt that this plan represents a radical departure. But what may not have been obvious is just how radical – and just how implausible – it is.

The elaborated parts of the plan are for health. Support for Medicaid would be turned into block grants to the states, which would presumably cut back on support. Support for healthcare for the elderly would be turned into federal contributions towards private medical insurance.

Even these radical changes would leave the share of federal support for health spending at 5 percent of GDP. Yet this would also be 40 percent of the share forecast in the CBO’s baseline. The clever part is that the plan would only prevent people who reach 65 from 2022 from joining Medicare. Support for health insurance for the elderly would also be means tested and vary with the health of the beneficiary. Overall, suggests the CBO, the elderly would bear 68 percent of the costs of insurance by 2030.

As it notes: “That greater burden would require them to reduce their use of healthcare services, spend less on other goods and services, or save more in advance of retirement than they would under current law.”

The US has the highest maternal and infant mortality rates among the high-income countries, and among the lowest life expectancies. The result of these cutbacks in spending on health for the poor and the old would be further deterioration. Is this really politically acceptable?

Yet the plan has other surprising aspects: first, social security would be untouched; second, non-health, non-social security and non-interest, spending (“the residual”) would be cut to 6 percent of GDP in 2022 and be constant in real terms after 2021.

This residual category includes defence, most veterans’ programmes, mandatory spending on federal civilian and military retirement, unemployment compensation, earned income and child tax credits, scientific research and much else. The plan entails the almost complete disappearance of these residual functions other than defence, since it is hard to see why spending on the latter should fall much from the average of 4½ percent of GDP of the past decade. The rest would then be down to 1½ percent of GDP by 2022. Indeed, in the very long run, even spending on defence would collapse. Assume, for example, that spending on all the non-defence areas in the “residual” would be 1½ percent of GDP in 2050. Then defence spending would be a mere 2 percent of GDP. Is this a Republican plan?

Assume, instead, that “residual” spending returns to its long-run average of 8 percent of GDP. Assume, too, that spending on health is kept below 8 percent of GDP – an extraordinary turnround. Then non-interest spending would still be 22 percent of GDP in 2050 and the fiscal deficit would be well over 3 percent. In short, revenue would have to be higher, even under these highly optimistic assumptions.

The Ryan plan is a “reductio ad absurdum” – a disproof by taking a proposition to a logical conclusion. It would turn the government into a miserly provider of pensions and health insurance. These functions would absorb three-quarters of non-interest spending by 2050. Other functions, including even defence, would collapse. This is most unlikely to happen. Indeed, even if the government were astonishingly successful in curbing the growth of spending on health, the share of federal spending in GDP is almost certain to be above 20 percent.

A long-term fiscal fight looms. The solution may even have to come out of a crisis. But Mr Ryan has given the president an opportunity, by defining what surely will not happen. Mr Obama must seize it.